SPEECHES & TESTIMONY

“Where Are We? And Where Should We Be? Thoughts on MF Global and High Frequency Trading”

Address by Commissioner Scott D. O’Malia at the Center on Financial Services Law of New York Law School

January 31, 2012

Introduction

Ron, thanks for that introduction and thanks for inviting me to speak today.

I am honored to be here at New York Law School, near the heart of the Financial District. Recently, all of my speaking engagements involve the Dodd-Frank Act. But, here, just two subway stops from the post-bankruptcy headquarters of MF Global, Inc.1 (“MF Global”), I thought it apropos to do something that unfortunately seems radical. I am going to focus on futures markets and futures customers.

It has been exactly three months since the Securities Investor Protection Corporation (“SIPC”) began insolvency proceedings against MF Global.2 Despite reams of releases and presentations from the SIPC trustee, futures customers have about the same information regarding the recovery of their funds today as on Day 1. Which is not much. Futures customers – including farmers, ranchers, and manufacturers – have been suspended in excruciating limbo, wondering when they will receive their funds. All they can do is to meekly fill out the claims forms presented by the SIPC trustee, all of which are due today. This situation is intolerable and unacceptable.

Instead of taking action to comprehensively identify and address vulnerabilities in futures customer protection, the Commission continues its all-consuming fixation on swaps regulation. Since the Dodd-Frank Act became law, the Commission has acted like a little child, abandoning the old toy and “swapping” them out for the new. It has concentrated on swaps rulemaking, while averting its gaze from the futures markets and their developments.

Today, I am going to buck that trend. I am going to focus on two developments of critical concern to the futures markets and futures customers. First, I will address MF Global and its implications for customer protection. Second, I will address high frequency trading (“HFT”) and preview some of my initiatives.

To be clear – both MF Global and HFT may involve extraordinarily complex issues. It is time for the Commission to begin a public discussion on these issues. I hope that this speech will be seen as a useful first step.

I do not have all of the answers. But I do have some thoughts. In the detailed discussion that follows, I want to make sure that two messages do not get lost.

First, more regulation does not mean more safety. Instead of drafting new regulations, the Commission may need to focus on identifying weaknesses in existing frameworks and on strengthening Commission oversight.

Second, Commission regulation and oversight cannot substitute for market discipline. The Commission has always been a leader in collecting and providing data. It needs to continue that leadership. In light of MF Global, the Commission needs to ensure that all customers within our jurisdiction have the information that they need to choose an intermediary within their risk tolerance. As a first step to understanding HFT, the Commission needs to develop a definition of HFT.

MF Global: What happened?

I’m sure some of you have followed the collapse of MF Global closely. Others of you are probably closely following your reading from Ron so you don’t fail out of law school. So let me explain MF Global in the context of futures regulation; MF Global was an intermediary. Basically, it executed and cleared futures contracts on behalf of customers.

As an intermediary, MF Global held funds from customers to margin (e.g., guarantee) futures contracts. As an intermediary, MF Global had a fundamental duty to segregate futures customer funds. Specifically, it was required to keep futures customer funds separate from proprietary funds. Further, MF Global was required to refrain from using futures customer funds for proprietary purposes. Every dollar that you deposit with the bank belongs to you, right? Similarly, every dollar that futures customers deposited with MF Global belonged to them.3

On October 31, 2011, MF Global was placed into insolvency.4 Simultaneously with the insolvency, it became clear that a significant portion of MF Global futures customer funds was missing. Currently, estimates of the amount missing range between $600 million to $1.2 billion.5 Every dollar of this amount belongs to a futures customer – from a rancher in Montana to a farmer in Kansas.

Since MF Global, many have said that we were lucky because the collapse did not have systemic consequences. I don’t share this view. Nor do the thousands of futures customers that have lost access to money that rightfully belongs to them. After all, segregation of customer funds forms the foundation of our customer protection regime. MF Global has shaken that foundation. Now, the Commission must take action. We must show that violations of segregation will not be tolerated.

MF Global: Where are we?

As Ron mentioned in my introduction, approximately two weeks after the MF Global collapse, I issued a statement on next steps (the “Statement”).6 I would like to expand on that Statement today. Those of you from New York may find the structure of the Statement and the rest of this speech to be faintly familiar. That is because the structure echoes the broken windows theory.7 The MF Global collapse was a huge broken window in the Commission’s neighborhood. To restore public confidence and to deter future violations of the segregation requirement, the Commission has taken action. It needs to continue taking action.

First, the Commission must get to the bottom of how futures customer funds went missing at MF Global. Basically, it needs to determine how the window got broken. As you all know, the Commission’s Division of Enforcement is investigating MF Global (“Enforcement”). Although I can’t comment further on this investigation, I can emphasize that the Commission has authorized Enforcement to issue subpoenas.

Second, the Commission must shelter victims from the broken window. In the three months since MF Global, the Commission has worked hard to expedite transfers of customer positions and funds. The MF Global shortfall is unprecedented in scope. Moreover, MF Global was dually registered with the Securities and Exchange Commission (the “SEC”) and the Commission. As a result, SIPC8 and its trustee have the primary responsibility for conducting the insolvency proceedings. The Commission has been relegated to a supporting role. As of December 22, 2011, former MF Global futures customers have received 72 cents for each dollar that they deposited with MF Global. This outcome is unacceptable.

In addition to expediting transfer and participating in insolvency proceedings, the Commission has worked hard to ensure that MF Global customers receive 100 cents on the dollar as soon as possible. The Commission’s Division of Swap Dealer and Intermediary Oversight (“DSIO”) is tracing transfers from the futures segregated accounts through the MF Global organization. Of course, DSIO can only review the books and records that they can access. In the U.S. alone, the MF Global insolvency involves two regulators9 and two trustees.10 I want to call on all involved to make sure that the Commission has full access to relevant books and records and witnesses.11 Otherwise, recovery for MF Global customers may be delayed needlessly.

MF Global: Where should we be?

To restore public confidence, the Commission can’t just focus on the one broken window represented by MF Global. We need to identify delinquencies in our neighborhood, and systematically address such delinquencies. We need to deter violations of the segregation requirement, and to ensure that futures customers feel like they can safely and confidently transact in our markets.

I’ll tell you what the Commission should do, but first, let me be clear about what it shouldn’t do. There is a perception that MF Global happened because of a lack of regulation. That perception is mistaken. Both our governing statute – i.e., the Commodity Exchange Act (the “CEA”) – and our regulations require an intermediary – like MF Global – to segregate futures customer funds. Indeed, certain of our segregation requirements precede the formation of the Commission.12

Because MF Global did not result from a lack of regulation, I’m puzzled by the Commission’s attempts to regain public confidence through new regulation. I am particularly puzzled because the Commission’s most recent rulemakings don’t even address MF Global. In December of last year, the Commission approved a final rulemaking on the investment of futures customer funds. In that rulemaking, the Commission restricted the universe of permitted investments.13 Whereas I was in favor of these restrictions given the volatile economic environment, I’m not aware of any evidence that the MF Global shortfall was related to investments of customer funds. Additionally, earlier this year, the Commission approved a final rulemaking on the protection of cleared swaps customer contracts and collateral.14 In that rulemaking, the Commission enhanced protection of customer funds in the event of a double default. However, this protection only extends to cleared swaps customers. Futures customers – such as the ranchers and farmers bearing the brunt of the MF Global shortfall – do not benefit from such protection.

The Commission needs to stop addressing potentially fundamental issues through adhoc actions. Now is the time to articulate a thoughtful, coherent approach to strengthening our segregation structure. We owe futures customers at least that much.

As a first step towards a thoughtful, coherent approach, the Commission should direct staff to hold one or more roundtables on potential vulnerabilities in the current segregation structure. The Commission should then hold hearings on staff recommendations, as well as industry recommendations. Only through an open and public debate can the Commission ensure that its actions increase futures customer protection, while facilitating market discipline.

Shorter-Term Actions: Spot Checks to Confirm Segregation Requirements

What can the Commission do to increase public confidence in the shorter term?

Conceptually, our customer protection regime can be divided into pre-bankruptcy and post-bankruptcy regimes.15 The Commission can make no immediate changes to the post-bankruptcy structure. Such actions lie with Congress. Therefore, the Commission should focus in the shorter term on pre-bankruptcy actions.

In my previous Statement, I indicated that the Commission should immediately require that all intermediaries demonstrate compliance with the segregation requirements. I supported the Commission’s plan to review the largest intermediaries itself, while directing the self-regulatory organizations (“SROs”) to review the remaining intermediaries. The Commission and the SROs have completed their reviews. As the Commission stated on January 25, 2012, “[a]s of the review date for each [intermediary], all of the [intermediaries] were in compliance with the segregation…requirements.”16 Specifically, “…[intermediaries] held a total of approximately $166 billion in segregated accounts, which was approximately $13 billion (or 9%) in excess of the $153 billion owed to customers.”17

Whereas one large, comprehensive review is a step in the right direction, it’s not enough. In my Statement, I recommended that the Commission institute a system of spot checks for segregation compliance. These checks should be randomized as to date and should include an assortment of large and small intermediaries. The Commission could also coordinate these spot checks with the SROs. To date, the Commission has not acted on my recommendation. I continue to believe that a system of spot checks would deter intermediaries from maintaining segregation structures or practices that could be conducive to shortfalls – just like random police patrols can deter vandalism. I also believe that instituting such a system would be one of the most effective shorter-term actions that the Commission could take to increase public confidence. I urge the Commission to reconsider the idea of spot checks, and the idea of taking appropriate enforcement action against any intermediary that fails such spot checks.

Middle-Term Actions: Pre-Bankruptcy Customer Protection

Now, let’s turn to middle-term actions.

Market Discipline through Disclosure

First, the Commission must consider how to facilitate market discipline with respect to segregation. Specifically, I have urged the Commission to improve disclosures to customers. Recently, the Commission approved a new regulation requiring, among other things, swap dealers to “know their customers.”18 I would like to give all customers – whether futures or swaps – the ability to “know their intermediary.” MF Global dramatically changed its risk profile without disclosure to its customers. That is unacceptable. Customers need to have enough information to understand the risk profile of an intermediary and to evaluate risk profiles across intermediaries. To use a simple example – you can easily compare the features and rankings of law schools. A futures customer should be able to make a similar comparison between intermediaries.

Systematic Identification of Weaknesses in Segregation

Second, the Commission must systematically identify weaknesses in its segregation requirements, as applied. As I mentioned above, the Commission should direct staff to hold one or more public roundtables. Moreover, staff could begin examining discrepancy reports. What are discrepancy reports? Well, under current Commission regulation, an intermediary that knows or should know that it is under-segregated must file a report with the Commission and its SRO.19 I understand that many of these reports detail minor operational failures. Nevertheless, staff should examine such failures to discern any patterns of under-segregation.20

After these roundtables and examinations, staff should identify weaknesses to the Commission, and make recommendations to ameliorate these weaknesses. The Commission should hold hearings to ensure full and fair debate on these recommendations.

Strengthening SRO Supervision of Intermediaries

Our governing statute, the CEA, requires the Commission to serve the public interest by exercising oversight over SROs. In our regulatory structure, SROs are the front-line supervisors of intermediaries. In light of MF Global, the Commission should review SRO supervision practices.

First, the Commission must determine whether SRO examinations are occurring frequently enough. Currently, each SRO examines each intermediary within its remit for compliance with segregation requirements only once every nine to fifteen months.21 Regardless of what the Commission decides with respect to frequency, randomized spot checks could be structured to complement SRO examinations.

Second, the Commission must determine whether to require SROs to expand the scope and intensify the depth of their examinations. Currently, the SROs are required to comply with Financial and Segregation Interpretations 4-1 and 4-2 (the “Interpretations”). These Interpretations were issued in 1985 and 1999, respectively.22 The Commission should consider updating these Interpretations (and any applicable codification). For instance, the Commission should consider expanding the Interpretations to provide specific guidance on how an SRO would ensure that an intermediary had sufficient internal controls to guard against violations of the segregation requirement.23

I understand that the CME and NFA, among others, have formed a special committee to discuss segregation initiatives. In reevaluating the Interpretations, the Commission should work closely with the CME and NFA, as well as other front-line regulators. Additionally, the Commission should reach out to other regulators, whether domestic or international.

Strengthening Commission Oversight of SROs

In addition to reviewing and strengthening SRO examinations of intermediaries, the Commission must consider how best to discharge its statutory obligation to oversee the SROs. It already has started work on this issue. For example, in early 2011, even before MF Global, Commission staff initiated a review with the ultimate goal of enhancing the usefulness of the audited financial statements of intermediaries.24 However, the Commission should further consider how best to leverage its resources. For example, the Commission should consider the use of technology to enhance supervision. I believe cooperation with industry, which has much greater technological depth and capacity, can be beneficial.

To emphasize again, more rulemaking does not mean more safety. In certain instances, safe harbors or best practices may work best. After the Commission examines the data in its possession and works with the SROs to strengthen examination practices, the Commission can determine the most appropriate form of action.

Long-Term Actions: Post-Bankruptcy Customer Protection

MF Global highlighted a number of issues with post-bankruptcy customer protection. Only Congress can fix this portion of the window. The Commission needs to consider making recommendations to Congress on amendments to the Bankruptcy Code.

Greater Commission Voice in Bankruptcy Decisions

First, the Commission needs to have a greater voice in insolvency proceedings implicating a dually-registered securities broker-dealer and futures commission merchant. As I mentioned above, MF Global was such a dual-registrant. SIPC placed MF Global into insolvency, and the SIPC trustee is responsible for liquidating MF Global. In contrast, the Commission has a more limited role in the liquidation.25 This dynamic is not optimal. The interests of futures customers are not always aligned with the interests of securities customers. The Commission should provide Congress with recommendations to increase the voice of the Commission. One potential recommendation is for the Commission to have the power to appoint its own trustee. That trustee would exclusively represent the interests of futures and swaps customers.

Customers First: The Super Lien

Second, the Commission should recommend that Congress clearly and specifically confirm that customers are always first in line. All money in segregated customer accounts must go to customer claims first. If there is a shortfall, the intermediary’s proprietary assets must go to customers first. In certain cases, not even proprietary assets may be enough to cover the shortfall. In that event, the proprietary assets of any affiliate of the intermediary26 should go to customers first. No creditor should come before a customer.

I realize that explicitly putting customers first may impose costs on intermediaries. However, an intermediary operates as an agent of its customers. It has a fundamental duty to make sure that it segregates each and every dollar it owes them. If an intermediary violates such duty, it is only just to minimize customer suffering. Creditors, knowing that their claims could be subordinated if there is a shortfall in insolvency, would have incentives to ensure that an intermediary has adequate internal controls to prevent segregation violations. Similarly, if customers are first in line for the proprietary assets of affiliates, the controlling parent company also has incentives to strengthen internal controls.

Reconsideration of Pro Rata Distribution

Third, the Commission should examine whether to recommend that Congress alter the pro rata distribution requirements of the Bankruptcy Code.27 Right now, if there is a shortfall in segregation, customers would share the loss proportionally. To be clear – they would share the loss regardless of whether their funds were held in one account or in separate, individual accounts. A number of market participants have stated that pro rata distribution exposes them to risks that they cannot quantify or control.28 These market participants include large pension funds that use both futures and swaps to hedge their risks. The Commission is currently exploring whether a regulatory solution is possible. I would urge the Commission to simultaneously delve into whether to advance a statutory solution.

Government Insurance May Not Work

Finally, in light of MF Global, I often hear arguments advocating for a government insurance scheme that would function like SIPC. I’m skeptical, given that customers in our markets need quick access to their funds to meet the margin calls that happen every day. Insurance, by its very nature, is slow. I’m even more skeptical, given the size and institutional nature of the futures markets and the swaps markets. Just to put some real numbers into the debate – currently, estimates of the MF Global shortfall range between $600 million to $1.2 billion. According to the SIPC website, “[f]rom the time Congress created it in 1970 through December 2010, SIPC has advanced $1.6 billion…”.29 Further, according to the website, SIPC only has a reserve of slightly more than $1 billion.30 Therefore, one incident like MF Global could essentially eliminate the reserve of a SIPC-like entity.

High Frequency Trading: What is the problem? And how can we solve the problem?

I mentioned at the top of my speech that there will be two topics. For those of you that have borne with me, I have strolled through the MF Global section of our neighborhood and have reached the HFT section. As you may know, we are approximately three miles away from the New York Mercantile Exchange. Since 2006, trading on that Exchange has shifted from the pit to electronic platforms. The technology of trading has evolved enormously since that shift. In contrast, Commission oversight has not kept pace. When I first joined the Commission, technology was definitely one area where the Commission needed to make some repairs. Using the broken window analogy – imagine there is no window, but a large gaping hole covered by plastic being whipped by the wind.

The Technology Advisory Committee and the May 6th Crash

To address this issue, I revived the Commission’s Technology Advisory Committee (“TAC”) in the summer of 2010. I ensured that TAC, during its inaugural meeting, focused on one of the most important technological evolutions in trading behavior: algorithmic trading. This decade, we have observed constant increases in the speed and volume of trading. These increases are challenging the ability of the exchanges, as well as the Commission, to ensure market integrity. What do I mean by market integrity? I mean the capacity of the market to reflect the forces of fundamental supply and demand.

The May 6th crash happened before the second TAC meeting. For those of you that may not have followed the crash – on May 6, 2010, in mere minutes, the equities and derivatives markets fell an unprecedented $1 trillion. Thankfully, the markets recovered. But the May 6th crash gave all of us a look at how terribly things can go when the right safeguards are not in place. I ensured that the second TAC meeting was devoted to developing consensus around the deployment of pre-trade risk controls to mitigate the possibility of another May 6th crash. The TAC has generated several recommendations, including: (i) pre-trade quantity limits on individual orders and price collars; (ii) execution and message throttles; (iii) a “kill button” on existing orders; (iv) clear exchange cancellation policies for erroneous trades and orders; and (v) trading functionalities that operate within parameters set by clearing firms.

In the discussions around the second meeting, however, the TAC encountered a fundamental problem. There was little to no understanding of the trading patterns on our markets. There was no consensus, e.g., on what constituted automated trading, what constituted algorithmic trading, and what constituted HFT. There was also no consensus on how each type of trading affected our markets. It was like having no consensus on what constitutes a broken window.

Establishment of a Subcommittee on Automated and High Frequency Trading

I believe that this lack of consensus is impeding the ability to have a public debate on different trading patterns and their effects on our markets. To try to reach some consensus, I am announcing my intention to create a new TAC subcommittee to specifically focus on defining and identifying HFT within the futures, swaps and options markets. In the interest of ensuring that this subcommittee has diverse and qualified members, I have requested that the Commission call for public nominations in the FederalRegister. Some of you in this room may have some experience in this area, and/or have some thoughts as to who should serve on the subcommittee. By all means, respond to the notice. We want the best and brightest to populate the panel to develop useful definitions for these traders and their trading behavior.

Conclusion

Until just recently, I thought I would need to immediately head back to Washington, D.C. after this speech to prepare for a Commission vote the next day. You may ask – what was supposed to be the topic of this vote? And I would have answered – the definitions of “swap dealer,” “major swap participant,” and “eligible contract participant.” In other words, nothing to do with futures markets and futures customers.

In light of MF Global and HFT, the Commission can no longer afford to devote the majority of its resources to swaps regulation, thus ignoring the rest of its mission. The Commission needs to turn back to its fundamental objectives since its creation in 1975 – namely, to ensure the integrity of futures markets and to protect futures customers. The Commission must continue focusing on the broken window represented by MF Global. However, it also needs to develop a thoughtful, coherent approach towards preventing, detecting, and deterring other broken windows. Empowering futures customers with information about their intermediaries, and enabling futures customers to exercise market discipline are central to such an approach. Strengthening customer protection, both pre- and post-bankruptcy, is also central. In that vein, I am particularly interested in hearing your reactions regarding the super lien.

Regarding HFT, the Commission needs to enable the public to have a thoughtful and coherent debate. It is critical, therefore, for the Commission to build consensus around the definition of HFT. I am hopeful that devoting a TAC subcommittee to this issue would advance this consensus. We should not be issuing new government dictates before properly identifying the problems and solutions.

In order to develop thoughtful, coherent approaches, the Commission must involve the public. Given the importance of both futures segregation and HFT, debates on appropriate actions need to happen in the light. The Commission needs to hold staff roundtables and hearings, to ensure full and fair consideration of all alternatives.

2 As I will discuss in more detail below, MF Global was dually-registered as a futures intermediary (i.e., a futures commission merchant) and a securities intermediary (i.e., a securities broker-dealer). This dual registration enabled SIPC to place MF Global into bankruptcy, and to ask the bankruptcy court to appoint a trustee. What is SIPC? As its website describes, “when a [securities broker-dealer] is closed due to bankruptcy or other financial difficulties and customer assets are missing, SIPC steps in as quickly as possible and, within certain limits, works to return [securities] customers' cash, stock and other securities, and other customer property.” In general, SIPC is bound to protect the interests of securities customers, but not futures or swaps customers. See http://www.sipc.org/who/sipcmission.cfm.

3 Just like a bank, an intermediary – like MF Global – is permitted to invest customer funds. There are limits, however, to such investments. See Regulation 1.25, 17 C.F.R. § 1.25 (Investment of Customer Funds). Regardless of such investments, the intermediary must segregate – at all times – an amount equal to 100 cents on each and every dollar that its futures customers deposit.

4 The parent company of MF Global – i.e., MF Global Holdings Ltd. (“MF Global Holdings”) – filed for bankruptcy on the same day. By some accounts, that bankruptcy is the eighth largest, by assets, ever in the United States. See, e.g., Shira Ovide, MF Global: Likely Among the 10 Biggest Bankruptcies Ever, The Wall Street Journal, Oct. 31, 2011, http://blogs.wsj.com/deals/2011/10/31/mf-global-likely-among-the-10-biggest-bankruptcies-ever/.

10 As I stated previously, the SIPC trustee is responsible for liquidating MF Global. However, MF Global had a parent – i.e., MF Global Holdings. Another trustee is responsible for the reorganization of MF Global Holdings under Chapter 11 of the Bankruptcy Code.

Moreover, MF Global had extensive international operations. Therefore, there are separate insolvency proceedings in each jurisdiction where MF Global had an affiliate. One of the largest of these proceedings is happening in the United Kingdom.

11SeeIn re MF Global, Inc., Case No. 11-2790 (MG) SIPA, Trustee’s Sixty Day Report on Status of Liquidation (Bankr. S.D.N.Y. Jan. 12, 2012) (stating “…certain complications have arisen around issues such as attorney-client privilege. The Trustee has waived reliance on this privilege for pre-filing date documents in an effort to facilitate transparency and regulatory investigations, while the Chapter 11 Debtors have sought to preserve privilege, even as to some [MF Global] documents and personnel. Despite some frustration on the Trustee’s part over these complications, investigation and coordination have continued.”).

12 For example, the first version of Regulation 1.20, 17 C.F.R. § 1.20, was published in the Federal Register in 1968. The Commission was formed in 1975.

15 Our regulations reflect this division. For example, the regulations for futures segregation pre-bankruptcy are found in part 1, 17 C.F.R. pt. 1. In contrast, the regulations for customer protection post-bankruptcy are found in part 190, 17 C.F.R. pt. 190.

20 For example, an intermediary may house the staff responsible for segregation compliance in one operational unit, and the staff responsible for authorizing transfers from segregated accounts in another operational unit. Miscommunications between the two operational units may easily result in the intermediary being out of compliance with segregation requirements. If the reports show that such miscommunications have resulted in a pattern of under-segregation across intermediaries (or even within one intermediary), the Commission should note such pattern.

21 Each SRO may also perform a limited examination of an intermediary for cause.

22 The Commission has proposed codifying the central elements of the Interpretations in Regulation 1.52, 17 C.F.R. § 1.52.

23 As an example, an intermediary must verify that a withdrawal from customer accounts would not lead to under-segregation. It must conduct this verification before the withdrawal. See, e.g., Regulation 1.23, 17 C.F.R. § 1.23. The Commission should develop criteria that an SRO could apply in determining whether the verification procedures of a particular intermediary are sufficient.

24 Regulation 1.10, 17 C.F.R. § 1.10, requires an intermediary to submit an annual financial report, certified by an independent public accountant, to the Commission and each relevant SRO. Commission staff reviews the annual financial reports.

25 The Commission only has the right to raise issues and be heard in the insolvency proceedings. See 11 U.S.C. 762(b) (stating “[t]he Commission may raise and may appear and be heard on any issue in a case under this chapter.”).

28 For example, if an intermediary experiences losses on investments of customer funds, those losses would be subject to pro rata allocation should that intermediary become insolvent. Currently, the intermediary may not provide its customers with sufficient information to evaluate its investment risks.